Download The Short-Run Trade-Off Between Inflation and Unemployment

Chapter 5



Phillips curve: shows the short-run trade-off
between inflation and unemployment
1958: A.W. Phillips showed that
nominal wage growth was negatively
correlated with unemployment in the U.K.
1960: Paul Samuelson & Robert Solow found
a negative correlation between U.S. inflation
& unemployment, named it “the Phillips
Curve.”

“The Phillips curve shows the combinations of
inflation and unemployment that arise in the short
run as shifts in the aggregate-demand curve move
the economy along the short-run aggregate supply
curve” (803).

PL=100 in 2020

Two outcomes are possible in 2021
 If AD is high… PL rises by a lot (output increases
substantially) (B)
 If AD is low… PL rises by a little (output increases slightly)
inflatio
P (A)
n
SRAS
105
103
B
5%
A
AD2
B
A
3%
PC
AD1
Y1
Y2
Y
4%
6%
u-rate

Both graphs are connected

As “A” moves to “B” the output increases
 Higher output= higher demand for workers
 Higher demand for workers= lower unemployment

As “A” moves to “B” the PL increases
 Increasing the PL increases the rate of Inflation

Fiscal and monetary policies affect the AD;
therefore, the PC offers policymakers a menu
of choices:
low unemployment with high inflation
 low inflation with high unemployment


anything in between


Natural-rate hypothesis: the claim that
unemployment eventually returns to its normal
or “natural” rate, regardless of the inflation rate
Based on the classical dichotomy and the
vertical LRAS curve
P
Inflatio
n
LRAS
LRPC
high
inflation
P2
P1
AD2
AD1
Natural rate
of output
low
inflatio
n
Y
Natural rate of
unemployment
u-rate

Since the LRAS curve is vertical, and output
stays constant, any increase in AD just
increases Inflation.

Expected Inflation:

Measure of how much people expect the overall PL
to change




Unemployment Rate (UR)
Natural Rate of Unemployment (NRU)
Actual Inflation (AI)
Expected Inflation (EI)
UR= NRU+ a(AI – EI)
a= in a parameter of how much unemployment responds to unexpected inflation
Short run
Fed can reduce u-rate below the natural u-rate
by making inflation greater than expected.
Long run
Expectations catch up to reality,
u-rate goes back to natural u-rate whether
inflation is high or low.

Natural-Rate Hypothesis:

Claims that unemployment eventually returns to its
normal, or natural, rate, regardless of the rate of
inflation


Supply shock:
an event that directly alters firms’ costs and
prices, shifting the AS and PC curves
Example: large increase in oil prices
P
Inflatio
n
SRAS2
P2
SRAS1
B
A
A
P1
Y2
Y1
B
A
D
Y
PC2
PC1
U-Rate

SRAS Curve shifts left:



Output decreases
Price level increases
Unemployment rises

Sacrifice Ratio:


The number or % points of annual output lost in the
process of reducing inflation by 1% point
Rational Expectations:

The theory that people optimally use all the
information they have including information about
gov.t policies, when forecasting the future

Typical estimate of the sacrifice ratio: 5


To reduce inflation rate 1%,
must sacrifice 5% of a year’s output.
Can spread cost over time, e.g.
To reduce inflation by 6%, can either


sacrifice 30% of GDP for one year
sacrifice 10% of GDP for three years

Ex.

Fed claims that they’re going to reduce inflation
 Expected Inflation decreases (SRPC shifts downward)

Result:
 Disinflations can cause less unemployment that the
traditional sacrifice ratio predicts.